What Is Step-Up Loan

Mr. Ajoy, an MBA professional, 26 years of age, is currently living in a rented apartment. He decides to buy a house for himself, and has spotted a dream house he would like to possess. But he is being constrained, as he is not getting the quantum of home loan he requires, because the evaluation for determining the loan amount is being done on the basis of his his current salary. Step-up-loan is perhaps what Mr. Ajoy should look for.

What is a step-up-loan?

It is a loan given by the bank/financial institution to the borrower based on his future/ expected income. The lending institution takes a call on the professional growth of the individual. This will result in the borrower getting a larger loan amount that what he is currently eligible for. In effect, the borrower is leveraging the potential increase in salary to obtain a higher loan today. What distinguishes a step-up-loan from a plain vanilla loan product is the fact that, potential earnings are taken into consideration, which pushes up the cash inflow enabling the financial institution to offer the borrower a higher loan amount.

Market information suggests that the step-up-loan would push up the loan amount eligibility by anywhere between 5% and 30% depending on the individual i.e. government employee or an information technology employee etc. These loans are called by various names by different financial institutions. E.g. SURF (Step up Repayment Facility) by HDFC, Corp Flexihome loan by Corporation Bank.

Who is best suited to get this loan?

Strong contenders for this loan would typically be double income households, young working professionals who are at the onset of their career. That’s because the premise on which this product functions is that the borrower’s cash inflow will increase on account of an increase in salary going forward. This loan is given on a case-to-case basis only. Besides, it is not offered by all financial institutions because of high risk to the lender.

In the case of Mr. Ajoy, he stands a high chance of getting a loan because he is a young professional at the beginning of his career.

Features of step-up-loans

Structure: This product is structured in a manner such that the EMI’s increase over the tenure of the loan (unequal EMIs). This means that the EMIs are low initially, and as the loan progresses in age, the EMI amount begins to increase. This is akin to balloon repayment. A large proportion of the EMI during the initial phase goes towards servicing the loan, and later as the EMI increases, the principal amount also starts getting covered.

The reason why it is structured in this manner is because as time progresses on account of an increase in cash inflow, (the basic premise on which this product functions) the borrowers capacity to pay higher EMIs increase. Thus this product is thus apt for early borrowers, who do not have high income initially and hence cannot afford high EMIs in the early years.

Step-up can happen in different phases depending on the need of the borrower- yearly, alternate years, five years or at some other time intervals. For e.g., for a 20 year home loan, the step up could happen in year 3, and year 10 which means for the first 3 years bulk of the EMI goes towards servicing the loan.

High overall Cost on account of Balloon repayment

In comparison to a plain vanilla loan product, step-up-loans tend to be costlier because principal repayment takes place only after a certain period, so you tend to only service the loan early on- you’re paying interest on the entire principal. Also, if the loan is a floating rate loan and interest rates are heading higher, costs will further increase as the base on which the rate of interest is calculated is high.

Tax benefits: Tax benefits reduce the cost of borrowing. Under section 24 of the Income Tax Act, interest on home loan is tax deductible to the tune of Rs. 150,000. This proves to be beneficial for a step-up-loan borrower, because large part of the initial instalments/EMIs goes towards payment of interest helping him to maximise the tax benefits on the interest element. This would reduce the cost of borrowing to that extent.

Risks

Interest rate risk: This is a key risk for the borrower especially because the principal repayment in the initial stages is very low. It is best to go for a fixed rate option especially in times when the interest rate cycle is turning upwards.

Lower than expected cash inflow: Less than imagined increment, loss of job can spell disaster because as the loan progresses in age, the EMIs will increase. Hence it is essential to be prudent while forecasting what EMI you would be comfortable paying in the future. Take this loan only if you’re absolutely sure that you will have the means to repay high EMIs in the future.

This loan product is apt for individuals who are at the beginning of their careers and do not really mind the cost because they believe in their potential to earn higher income going forward. Don’t get carried away because your dream of buying a house will come true with the higher loan amount, Weigh the impact on your cash flows over the life of the loan before opting for this product.